By Mike Faden | American Express Credit Intel Freelance Contributor
8 Min Read | August 13, 2020 in Money
Mutual funds are professionally managed funds that pool money from many investors and use it to buy stocks, bonds, and other financial assets.
They offer a convenient way to diversify your investments and help your money grow – although they also involve risk.
There’s a huge variety of mutual funds to choose from, offering different levels of potential reward and risk.
If you’re looking to invest your money for the long term, you may have heard that investing in mutual funds is a popular way to do it. If you decide to go that route, you won’t be alone. In 2018, roughly 45% of U.S. households owned shares in mutual funds, and they poured $191 billion into those funds during the year, according to Statista.1
Like any responsible investor, you probably want to know more before investing your hard-earned cash in mutual funds – like how they work, how you invest in them, how they can earn you money, and what the risks are.
Mutual funds are designed to offer an easy way to invest in stocks or other financial assets that may potentially help your money grow faster than it would in, say, a savings account. Mutual funds’ faster growth comes at the risk of losing your money. Of course, savings accounts have their own benefits, like government-insured safety and fast-and-easy access to cash.
Mutual funds are created and operated by investment management firms. Each mutual fund sells shares to investors – including people like you and me – pools the money and uses it to buy a collection, or “portfolio,” of stocks, bonds or other financial securities. The firm’s investment managers decide which companies’ stocks or bonds they’ll add to the portfolio, and how much they’ll buy of each.
Mutual funds are popular because they generally offer four key features, according to the U.S. Securities & Exchange Commission:2
|Some Pros and Cons of Mutual Funds
|Professional management: you don’t have to research individual stocks yourself||You can’t select or change the stocks or other assets in each fund|
|Diversification: the risk may be lower because your money is spread across multiple stocks or other assets||You might get a lower return than if you pick a single winning stock|
|Many funds don’t charge for buying or selling shares in the fund||You always pay operating expenses, whether the fund increases or decreases in value|
To start investing in mutual funds, you can buy shares:
The price of a share in the mutual fund is based on the fund’s “net asset value” (NAV), which is the total value of the securities in the portfolio divided by the number of the fund's shares. This price can go up or down, based on the value of the securities in the fund at the end of each business day. If the price goes up, the value of your investment increases. If the price falls, your investment shrinks.
One convenient aspect of mutual funds is that you can invest in dollar amounts that work for you, rather than having to buy a specific number of shares. Some funds require an initial investment of several thousand dollars, but after that you may be able to add smaller amounts, perhaps as small as $100 at a time. You may also be able to set up automatic regular payments – say, monthly – that can be even smaller.
All mutual funds charge fees. There are two main types:
A fund with high fees must perform better than a low-cost fund to generate the same return on your investment. Even small differences in fees can mean a big difference to how much your investments grow over time, according to the SEC. For example, if you invested $10,000 in a fund with a 10% annual return and an expense ratio of 1.5%, your money would grow to roughly $49,725 after 20 years. If you invested in a fund with the same performance and expenses of 0.5%, you would end up with $60,858 – earning more than $11,000 extra.3
The good news is that fees have fallen over time. The average expense ratio for mutual funds that invest in stocks dropped from 1% in 2003 to 0.55% in 2018, according to an investment industry association.4
There’s an extraordinary variety of mutual funds to choose from – more than 9,600 in 2018, according to Statista. They vary widely in their performance, investment approach, and level of risk, so research carefully before you invest. The SEC recommends reading the “prospectus” that each fund is legally required to produce, which describes the fund’s investment objectives, risks, performance, and expenses.
Common types of funds include:
Some funds take an active money management approach: They aim to beat the stock market by picking winners and/or frequently buying and selling stocks to take advantage of short-term price fluctuations. These funds generally have higher fees. In contrast, index funds use a passive money management approach, which generally results in much lower fees. Instead of putting effort into picking winners, they simply adjust their stock holdings automatically when companies enter or leave the index they track.
Largely because of the lower fees, passively managed funds such as index funds have become increasingly popular. During 2019, they attracted more investment than actively managed funds for the first time, according to experts.6
You can earn money from a mutual fund in several ways, depending on the fund:
Mutual funds can provide a convenient way to invest your money in stocks or other financial assets that may help your money grow, without spending time researching and buying individual stocks. Still, you should research each mutual fund carefully before you invest, because there’s generally some risk involved.
1 “Mutual funds - Statistics & Facts,” Statista
2 “Mutual Funds,” U.S. Securities & Exchange Commission
4 “2019 Investment Company Fact Book,” Investment Company Institute
5 “Understanding the Risk/Reward Spectrum,” PIMCO
6 “End of Era: Passive Equity Funds Surpass Active in Epic Shift,” Bloomberg News